Responses to the Tax Cuts and Jobs Act

Published December 14, 2021
By Jon Durrant, James Gong, Jennifer Howard

In the Nick of Time: Performance-Based Compensation and Preemptive Responses to the Tax Cuts and Jobs Act

Congress has often used tax policy to regulate executive pay. In 1993, lawmakers responded to public outcry over perceived excesses in executive compensation by enacting Section 162(m), which placed a $1 million limit on the amount of executive pay that a company can claim as a tax deduction (the “million-dollar rule”). However, the limit did not apply to performance-based compensation, such as bonuses and stock options. Because of this exception, Section 162(m) actually resulted in a dramatic increase in total compensation due to the explosion in the use of stock options in executive compensation.

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced two major changes that may influence the structure of executive compensation: (1) reducing corporate tax rates from 35 to 21 percent and (2) eliminating the performance-based pay exception in Section 162(m). These changes provide incentives to maximize deductible compensation expense in 2017, before the TCJA goes into effect. It would have been reasonable for firms to expect existing compensation plans would be grandfathered as they were under the 1993 transition rule for Section 162(m). The grandfathering of existing compensation arrangements provides an incentive to modify contract terms to maximize both bonus and stock option compensation to preserve deductibility of performance-based pay in future years. Additionally, the tax rate reduction provides incentive to accelerate bonuses into 2017 to claim deductions at the higher pre­‑TCJA tax rates.

We examine annual changes in two performance-based components of executive compensation, bonuses and stock options. Our results show that the 2017 increase in performance-based compensation was higher than in previous years, consistent with our hypothesis that firms will increase compensation in an attempt to lock in and/or maximize the deductibility of existing performance-based compensation before the tax reform becomes effective. The TCJA also changed the definition of “covered employees” to explicitly include the CFO. We find that results for the CFO are generally weaker, smaller in magnitude, and/or less consistent compared to the CEO results. This is not surprising as CFO pay is about one-third of CEO pay and has smaller variation in change. In addition, fewer CFOs have total compensation above $1 million than CEOs, so the Section 162(m) limitation will affect fewer CFOs than CEOs.

Overall, our findings suggest that firms’ responded to the TCJA in the period before the TCJA became effective. In addition, our findings suggest that firms responded not only to the tax rate reduction, but also to the repeal of the exception for performance-based pay. Our study highlights the importance of studying changes in periods that precede tax law changes and not just focusing on the post-enactment period. This study adds to our understanding of the relationship between tax policy and executive pay by documenting that firms took actions to maximize and/or maintain full deductibility of performance-based compensation before the deduction was eliminated.